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Why Americans Must Keep Spending

NOTHING props up the economy more than consumers, and dips in their spending frighten forecasters. But that is all that has happened in recent years -- dips, not plunges. Consumers in America spend because they feel they must spend. More than in the past, the necessities of life, real and perceived, eat up their incomes.

That treadmill spending is good news for the economy. As a recovery takes hold, the biggest threat to its survival would be a downturn in consumer spending. That is not inconceivable: The support for recent spending -- the household cash generated through mortgage refinancings and tax cuts -- is disappearing, and a new source of cash, from many new jobs and many new paychecks, is not yet a reality.

But do not worry, various experts say. Consumers will keep spending anyway, going deeper into debt to do so if they must. They have too many needs, some that were luxuries only yesterday. A second car and child care, for example, are now necessities for millions of households with two earners commuting to jobs. Mall-crawling, for all its popularity, is increasingly the anomaly, not the norm, in the vast realm of personal consumption.

So as the typical household keeps spending, and as other sectors of the economy revive, the country will prosper. There is considerable optimism on this point among the nation's forecasters. All but one of the 51 surveyed by Blue Chip Economic Indicators expect the economy to grow more strongly in 2004 than it has in the past 33 months -- expanding at a 4 percent annual rate, up from less than 3 percent through most of the past three years.

Business investment, she notes, is already on the rise, profits are soaring and stock prices have gone up, reawakening the wealth effect. Above all, consumption outlays, which never flagged during the 2001 recession and the weak economic growth thereafter, surged in the third quarter, contributing significantly to economic growth. Not surprisingly, mortgage refinancing reached a peak in this quarter, as homeowners took advantage of low interest rates, and so did the effects of the tax cuts championed by the Bush administration. Without that support, consumer spending may dip in the months ahead, but it will not plunge. Too much of a household's income goes for items now considered necessities.

This spending truly matters. Consumers are purchasing roughly $7.6 trillion a year in goods and services. Their outlays represent about two-thirds of the nation's economic activity, so when people slow their buying, the growth of the economy also slows. But that seldom happens anymore.

Look back to 1947, a total of 227 quarters. In only 20 of these three-month periods did a drop or weakness in consumer spending curb economic growth or weaken an expansion, and most of that occurred in the early decades. Only three times in the last two decades has consumer spending faltered enough to damage the economy -- twice during the 1990-1991 recession and once as the slow recovery got under way. That drag disappeared in the 2001 recession, the first since the 1940's in which consumer spending rose enough to limit the contraction instead of contributing to it.

This suggests that consumers are earmarking an increasing share of their disposable income for purchases that are, or that they consider, necessary, even in recessions. ''The spending you can't fool around with has gone up -- for homes, health insurance, day care, car payments,'' said Elizabeth Warren, a Harvard Law School professor and co-author of ''The Two-Income Trap'' (Basic Books, 2003). She argues that the optional portion of consumer spending has become relatively small.

SO even if more jobs and more paychecks fail to materialize, the typical household will keep up its spending, Ms. Warren contends. People will do so by going into debt, or deeper into debt, to acquire what they view as essentials. Such consumption will help sustain the economy in the coming presidential election year, although painfully for many households. ''It is hard to construct a happy story for 2004 unless we consistently create a significant number of jobs, which we have not done yet,'' said Mark Zandi, chief economist at Economy.com, a research and consulting firm.

The happy story will materialize once the strengthening economy is consistently generating 300,000 jobs a month, said Jared Bernstein, senior labor economist at the Economic Policy Institute. So far, job creation, while finally rising, has not reached half that level. If the level is reached soon and maintained over the next year, that would be enough to absorb the nearly 3 million people who want to work and begin to push wages up. Real disposable personal income -- that is after-tax income -- has risen by 3.2 percent over the past year, but that resulted almost entirely from the mortgage refinancings and tax cuts, the Commerce Department reported. The wage portion has been stagnant for nearly three years.

The growing list of purchases that households consider essential helps explain why ''personal consumption expenditures,'' as the Commerce Department calls them, held up so well over the last 33 months, which included an eight-month recession followed by persistently weak economic growth.

There have been 10 recessions since World War II, and this was the first in which consumer spending provided support instead of dragging the economy down. With jobs disappearing and wage income going nowhere since 2001, that support should theoretically have given way this time, too. But households regarded an increasing portion of their outlays as essential.

What is more, they had nonwage means to pay for them. Rising home prices and falling interest rates allowed homeowners to withdraw tens of billions of dollars in equity from their homes through mortgage refinancing. Tax cuts have also fueled consumer spending. The two together put more than $200 billion into people's pockets this year. The falling interest rates also encouraged households to run up other debt: car loans, for example, and on credit cards.

Still, while consumer debt, including mortgages, is at a record level -- approaching $8 trillion, according to the Federal Reserve -- the monthly repayment at nearly 14 percent of disposable income is manageable, according to Edward McKelvey, a senior economist at Goldman Sachs. The Federal Reserve's ''financial obligations ratio,'' which includes debt service as well as rent, auto leases, property taxes and homeowner insurance, comes in at 18 percent of disposable income. Both measures are at near-record levels, but not so high as to inhibit spending, thanks mainly to low interest rates.

''What consumers consistently tell us is that mortgage rates and car loan rates have never been lower, and that is an opportunity they don't think they should miss,'' said Richard T. Curtin, director of consumer surveys at the University of Michigan. ''They don't expect these rates to be lower in their lifetimes.''

Now these sources of cash flow -- particularly mortgage refinancing, the biggest source of all -- are drying up as interest rates begin to rise in a strengthening economy, and the tax cuts run their course. As a result, the total new stimulus from these sources will be around $100 billion in 2004, less than half this year's injection. Most of it will be delivered in the winter and spring in the form of tax refunds, as a result of the retroactive nature of this year's tax cut.

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''Our models tell us that modest increases in interest rates will sharply curtail mortgage refinancing by the end of the first quarter,'' said Douglas Duncan, chief economist at the Mortgage Bankers Association in Washington.

But economic rescue is at hand, the forecasters insist. They foresee rising employment that will lead to more wage income as the recovery takes root. Or, as James W. Paulsen, chief investment strategist for Wells Capital Management, put it: ''We are switching stimulants for the household.''

Consumer spending is not the only source of economic growth, of course. Government outlays and business investment are also big factors, but the former comes to $2.1 trillion annually and the latter to $1.2 trillion. So if consumer spending, the $7.6 trillion elephant, is pulling the nation's $10.8 trillion economy in one direction, neither of the other factors pulling in the opposite direction is likely to win the tug of war. That is particularly the case today. Government spending is barely rising, and business investment, although rising strongly, is limited mainly to replacement of aging computers, government data suggest. Given so much idle production capacity, economists say, business investment for expansion is not likely to kick in soon.

That makes the composition of consumer spending increasingly important in assessing the economy. If consumers were to decide that they could cut back on spending, the recovery would be in trouble. However, as long as they view much of their spending as essential, it should be sufficient to support the recovery.

Statistics compiled by the Commerce and Labor Departments are inconclusive on this issue because the line between discretionary and essential spending is hard to draw. ''They form a continuum,'' said Stephen Brobeck, executive director of the Consumer Federation of America, but the continuum, he said, is tilting toward more nondiscretionary spending.

Typical households -- those that account for more than half of the nation's personal consumption expenditures -- have two earners and one or two children, according to various experts in these demographics. The two earners bring home together $60,000 to $80,000 a year, and they disperse 70 to 75 percent of it for essentials: groceries, home costs, vehicles and fuel, public transportation, education and health care. That outlay is up roughly four percentage points since 1990, according to the Bureau of Labor Statistics.

More important is the remaining 25 percent or so of the spending. It could weaken the economy if it declined sharply enough. That 25 percent seems discretionary, but in many cases it is not, said Mark Cooper, director of research at the Consumer Federation. Take cable or satellite television, cellphones and Internet hookups. The majority of the nation's 111 million households have one or more of these items, and the proportion is rising. For all three, a household pays at least $130 a month in fees, all of it once considered discretionary. ''People have come to define their quality of life as being full participants in the information age,'' Mr. Cooper said, ''so they give up the connections slowly, and they feel deprived when they have to do without cable TV or cellphones or the Internet.''

What about designer wear, electronic gadgets, television sets? They are more easily sacrificed than housing or food in hard times. Yet expenditures are rising for this merchandise, too, strong evidence that they have been converted into essentials for many households through social pressures, says Juliet B. Schor, an economist and sociologist at Boston College and the author of ''The Overspent American'' (Basic Books, 1998). ''These lifestyle and expenditure norms have risen pretty dramatically for the middle class and the upper middle class,'' she said.

No one has been more forceful lately than Ms. Warren and her daughter, Amelia Warren Tyagi, a business consultant, in pushing the message that the typical household is increasingly diverting income to purchases they now see as essential. In their book, ''The Two-Income Trap,'' they define essential consumption more narrowly than Ms. Schor, excluding purchases that result from social pressure.

They see the pressure on a household to spend beyond its means as coming from two directions: Household incomes are rising more slowly than the costs, yet families keep up their spending because so much of it is needed to maintain a certain standard of living. Stretching to purchase a home in a community with a good school system, for example, is viewed by many as a necessity and not an option, now that public school quality has declined in so many less expensive communities. ''People will not give up these homes,'' Ms. Warren said. ''They have to be persuaded there is no hope before they do that.''

A third squeeze, the authors note, is that the typical household already has two adults at work. By contrast, in the early 1970's most households had one adult (usually the wife) still at home, available to take a job and supplement family income if the principal earner's wages fell short.

The arguments made by Ms. Warren and Ms. Tyagi resonate. Personal consumption expenditures, adjusted for inflation, have risen since 1973 at a faster average annual rate than median household income, similarly adjusted for inflation: spending is up at a 3.2 percent annual rate versus a 0.5 percent increase in income, according to recent government data.

As a result, a typical two-earner household with a $68,000 annual income today is earmarking 75 percent of it for such fixed costs as mortgage payments, child care, health insurance, cars and taxes. In the early 70's, only 54 percent of a typical household's $39,000 income went for the same expenses, the two authors maintain.

''What happens when income falls short is that people start increasing the risks they take to keep up their spending,'' Ms. Warren said. Cut off from mortgage refinancing, they turn to home-equity loans, which are now on the rise, and, if they cannot pay their debts, to personal bankruptcy. Bankruptcies have risen in each of the past three years.

In this situation, rising employment and the new paychecks that come with it are the lifesaver nearly every forecaster is counting on to sustain consumption. But the hiring will have to be robust, approaching 300,000 new jobs a month, Mr. McKelvey of Goldman Sachs said, echoing Mr. Bernstein. Otherwise it will not generate enough new disposable income to offset the rise in debt payments as interest rates go up -- and people might grow reluctant to take on new debt, even to buy essentials.

''That is the pessimistic scenario,'' Mr. McKelvey said. ''But in my mind there will be enough job growth; that is a more realistic scenario. The numbers today have created a sense that the process has begun to take shape, and in two or three months, we'll be there.''